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Are you Still using a ‘Rule of Thumb’ to Calculate Reasonable Compensation?

By Paul S. Hamann & Jack Salewski, CPA, CGMA

If you answered yes, my next question is why?  I was at a neighborhood wine party last week and had a conversation with Justin (not really his name).  I met Justin last year at the same event – a nice young man and entrepreneur who was doing very well for himself.  I asked how his business was going this year and he told me even better than last.

Justin asked me what I did again (he didn’t remember from last year) and I told him I developed software that determined Reasonable Compensation – .  His ears perked up a bit, it turned out he had recently had ‘the conversation’ with his CPA about Reasonable Compensation (his business was an S Corp).

Of course, I asked what advice he had been given.  Same as last year he told me – split my distributions and salary 50/50.  I cringed and then asked, respectfully, a little more about his business and what duties he performed.  He told me:

  • Planned on taking about $300,000 out of his company for 2015
    • Distribution = $150,000
    • Salary = $150,000
  • Income came from large and small equipment rental and sales
  • The services he provided to his S Corp amounted to about 40 hours a week; consisting primarily of bookkeeping; management of employees; maintenance of equipment.

I suggested he look into a more reliable method for determining Reasonable Compensation.  Long story short, he asked me to prepare a Reasonable Compensation Report for him.  The report concluded that based on the services he provided his S Corp, his Reasonable Compensation should be $70,000.

He was thrilled to start saving $8,300 in payroll tax compared with what he would have paid using the 50/50 rule.  He was also disappointed with his CPA.  I didn’t criticize his CPA, but being a quick study, Justin knew immediately he had already paid more payroll tax than was legally required.

Two hundred years ago it made sense for a poor pioneer to use his thumb as a measuring device, but times are different now.  Same for measuring Reasonable Compensation.  Even just four years ago, calculating Reasonable Compensation was a daunting and time-consuming process, reserved for only the most critical situations, typically involving an examination or court appearance.  Today, new RCReports software gives you the tools you need, right on your desktop, to determine Reasonable Compensation for your client.  It takes just a few minutes.

If Justin’s CPA had RCReports in her toolbox, she would have saved Justin $8,300 in payroll tax and he would have been impressed instead of disappointed.

Analysis: Rule of Thumb v. Reality for Justin

Justin Example

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